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CHAPTER-II CONCEPTUAL AND THEORETICAL DISCUSSION
OF FUTURES MARKET 2.1 Introduction
The chapter consists of four sections. Section one deals with the concept of
derivatives market, types of derivatives, economic functions of futures market and traders
in futures market. In Section two, theoretical models of futures price and hedging strategy
and theories of hedging have been discussed. Section three provides a detailed
description on derivatives trading in India and trading mechanism of futures market at
National Stock Exchange (NSE). Section four presents the conclusion of the chapter.
2.1.1 Definition and Uses of Derivatives
A derivative security is a financial contract whose value is derived from the value
of something else, such as a stock price, a commodity price, an exchange rate, an interest
rate, or even an index of prices. A derivative enables a trader to hedge some preexisting
risk by taking positions in derivatives market that offset potential losses in the underlying
or spot market.
The emergence and growth of market for derivatives instruments can be traced
back to the willingness of risk-averse economic agents to guard themselves against
uncertainties arising out of fluctuations in asset prices. Derivatives are meant to facilitate
hedging of price risk of inventory holding or a financial/commercial transaction over a
certain period. They serve as instruments of risk management. By locking-in asset prices,
derivative products minimize the impact of fluctuations in asset prices on the profitability
and cash flow situation of risk-averse investors. By providing investors and issuers with a
wider array of tools for managing risks and raising capital, derivatives improve the
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allocation of credit and the sharing of risk in the global economy, lowering the cost of
capital formation and stimulating economic growth. Now that world markets for trade
and finance have become more integrated, derivatives have strengthened these important
linkages between global markets, increasing market liquidity and efficiency and are seen
to be facilitating the flow of trade and finance. The financial derivatives gained
prominence in post-1970 period due to growing instability in the financial markets and
became very popular, accounting for about two-thirds of total transactions in derivative
products. In the recent years, the market for financial derivatives has grown both in terms
of variety of instruments available, their complexity and turnover. Financial derivatives
have changed the world of finance through creation of innovative ways to comprehend
measure and manage risks.
2.1.2 Types of Derivatives
The simplest types of derivatives are forwards, futures, options and swaps. To
illustrate a forward contract, consider the following example (unless otherwise stated, all
prices are in rupees per gram). Jewelry manufacturer Goldbuyer agrees to buy gold at Rs.
600 (the forward or delivery price) three months from now (the delivery date) from gold
mining concern Goldseller. This is an example of a forward contract. No money changes
hands between Goldbuyer and Goldseller at the time the forward contract is created.
Rather, Goldbuyer’s payoff depends on the spot price at the time of delivery. Suppose
that the spot price reaches Rs. 610 at the delivery date. Then Goldbuyer gains Rs. 10 on
his forward position (i.e. the difference between the spot and forward prices) by taking
delivery of the gold at Rs. 600.
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A futures contract is similar to a forward contract, with some exceptions. Futures
contracts are traded on exchange markets, whereas forward contracts typically trade on
OTC (over-the-counter) markets. Also, futures contracts are settled daily (marked-to-
market), whereas forwards are settled only at expiration.
Returning to the example above, suppose that Goldbuyer believes that there is
some chance for the spot price to fall below Rs. 600, so that he loses on his forward
position. To limit his loss, Goldbuyer could purchase a call option for Rs. 5 (the option
price or premium) at a strike or exercise price of Rs. 600 with an expiration date three
months from now. The call option gives Goldbuyer the right (but not the obligation) to
buy gold at the strike price on the expiration date. Then, if the spot price indeed declines,
he could choose not to exercise the option, and his loss would be limited to the purchase
price of Rs. 5. Alternatively, Goldbuyer may anticipate that the spot gold price is very
likely to decline, and attempt to profit from such an eventuality by buying a put option,
giving him the right to sell gold at the strike price on the expiration date.
Swaps are derivatives involving exchange of cash flows over time, typically
between two parties. One party makes a payment to the other depending upon whether a
price is above or below a reference price specified in the swap contract.
2.1.3 Economic Functions of Futures Market
• Many investors will use futures hedging as a risk management tool when they are
investing in many market areas. Hedging is the act of placing short-term positions
within the futures market, that are equally the same amount but they are on the
opposite side of their cash investments. If an investor is taking long positions
within one market, they will take short positions in the futures market. The hopes
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of this are that if one side is being hit with unfavourable price movements, the
other is gaining, thus avoiding total loss, and instead balancing out.
• Another important application of futures market is the price discovery which
means revealing information about future cash market prices through the futures
market and thereby makes the underlying assets more efficient.
• The futures market relocates risk from the people who prefer risk aversion to the
people who have an appetite for risk and permit trading at low transaction costs.
• Prices in a structured futures market not only replicate the discernment of the
market participants about the future but also lead the prices of underlying to the
professed future level. On the expiration of the futures contract, the prices of
futures congregate with the prices of the underlying. Therefore, futures are
essential tools to determine both current and future prices.
• Futures market helps to keep a stabilising influence on spot prices by reducing the
short-term fluctuations. In other words, futures market reduces both peak and
depths and leads to price stabilisation effect in the underlying spot market. • A significant accompanying benefit which is a consequence of futures trading is
that it acts as a facilitator for new entrepreneurs. The futures market has a history
of alluring many optimistic, imaginative and well educated people with an
entrepreneurial outlook, the benefits of which are colossal.
2.1.4 Traders in Futures Market
In India, most futures market traders describe themselves as hedgers and Indian
laws generally require that futures be used for hedging purposes only. Another motive for
futures trading is speculation (i.e. taking positions to profit from anticipated price
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movements). In practice, it may be difficult to distinguish whether a particular trade was
for hedging or speculation, and active markets require the participation of both hedgers
and speculators. Hedgers are those who enter into a futures market with the objective of
covering risk. Futures contract acts as a hedge when a position is taken in them which is
opposite to that of the existing or anticipated spot position. Thus hedgers sell futures
when they have taken a long position on the spot asset and they buy the futures in case
they have taken a short position on the spot asset. Besides, the speculators are those who
enter into a derivatives contract to make profit by assuming risk. They have an
independent view of future price behaviour of the underlying asset and take appropriate
position in futures contract with the intention of making profit later. Speculators facilitate
smoother and easier hedging through increased liquidity and reduced transaction costs.
Another group of participants in futures markets is that of the arbitrageurs. The
arbitrageurs do not take view on prices, like speculators do. They thrive on inefficiencies
of the market and so their actions help keep the market efficient and functioning well.
The arbitrageurs come into action once they find that the prices in the spot market and the
futures market, or in the futures market in respect of different maturities are deviating
from the normal. For example, if an arbitrageur finds that prices of futures contracts with
a certain maturity date is higher than what should it be in accordance with the price in the
spot market, he would step in to shout futures contracts and buy in the spot market. With
more and more people taking similar positions, the futures prices would tend to fall
relative to spot price. As the gap between the two prices narrows, the arbitrageurs would
earn profit. They will get profit from discrepancies in the relationship of spot and futures
prices, and thereby help to keep markets efficient.
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Jogani and Fernandes (2003) describe India’s long history in arbitrage trading,
with line operators and traders arbitraging prices between exchanges located in different
cities, and between two exchanges in the same city. Their study of Indian equity
derivatives markets indicates that markets were inefficient. They argue that lack of
knowledge, market frictions and regulatory impediments have led to low levels of capital
employed in arbitrage trading in India. However, more recent evidence suggests that the
efficiency of Indian equity derivatives markets may have improved.
2.2 Theoretical Models of Futures Prices
2.2.1 Normal Backwardation Model
The Normal Backwardation Model was propounded by famous economist Lord
Keynes. This model states that the current futures price is a downward biased indication
of the future spot price. For instance, a wheat farmer doing plantation today does not
know what price of wheat will prevail at the time of harvest. However, he can lock-in
price by selling futures contract for deliver around harvest time at the rate determined
today. If farmers are taking the short position (sell futures) to hedge, some group
(speculators) must take long position (buy futures). If the price at the time of harvest
happens to be the same at which futures contract was made, then the speculator has
provided the assurance of the same price much in advance, without any compensation. In
order to provide compensation to the risk assumed by the speculators, the spot price at the
time of maturity of futures contract must be higher than the price of the futures contract.
Therefore, futures price must underestimate the future spot price. The premise of Keynes
is based on the assumption that hedgers are net short and speculators are net long, and if
it is true the backwardation hypothesis holds.
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2.2.2 Contango Model
Contango model assumes the opposite of Keynes hypothesis. If hedgers are net
long and speculators are net short then the futures price must overestimate the spot price.
This is known as contango. This can happen because it is assumed that the speculators are
better informed about the conditions and inefficiencies of the market, and therefore they
become enthusiastic to buy and pull up the prices. Hence, the futures price is an
overestimate of expected spot price. Though it lacks rationale, contango can result due to
inefficient markets condition.
2.3.3 Cost-of-Carry Model
Cost-of-Carry model is used to determine the price of the futures contract, which
implies that futures represent the prospective price of the underlying asset in the spot
market. For example; if the futures is traded at 2500 and the cash market at 2450, (if cost-
of-carry model holds good) it implies that the futures will direct the next price move in
the spot market, thus the next price of the underlying asset will be approximately 2500.
The theoretical relationship between futures and spot prices can be explained by Cost-of-
Carry model which can be defined as:
Ft = St e(r-y) (T-t) …………… (2.1)
where, Ft is the futures price of the stocks at time t, St is the spot price of the stocks at
time t, r is the interest rate foregone while carrying the underlying stocks, y is the
dividend yield on the stocks and T − t is the remaining life of the futures contract.
Equation (2.1) is justified by a “no-arbitrage” assumption, since Ft > Ste(r-y) (T-t) would
enable investors to profit by selling futures and buying stocks, while Ste(r-y) (T-t) > Ft would
allow profits by buying futures and short selling stocks. The assumptions that underlie
these arguments are that future and spot markets are perfectly efficient, and that
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transaction costs are zero. This simple version of the model also assumes that the interest
rate and dividend yield are constant over the life of the futures contract, although in
practice they will vary, as will r − y, the net cost of carry of the underlying stocks. Most
importantly, in the real world, the existence of market frictions such as transaction costs,
margin requirements, short-sale constraints, liquidity differences and non-synchronous
trading effects may induce lead-lag relationship between the futures contract and its
underlying spot market. In addition, if there are economic incentives for traders to use
one market over the other, a price discovery process between the two markets is likely to
happen (Zou and Pinfold, 2001). This implies that futures and spot market prices are
complex in nature and can be traced under different market frictions through price
discovery mechanism.
Price discovery is a function of the cost-of-carry model, which implies that price
discovery will be true only if cost-of-carry model holds good. In other words, if at any
time the futures are mispriced then lead-lag relationship between futures and spot market
may be disturbed, which will result into wrong decision for the traders to take position in
the spot market on the basis of the price movement in the futures market. In addition, if
the futures are mispriced then hedging through arbitrage positions in the cash and the
futures market will not work in the interest of the traders. In addition, an efficient cost-of-
carry relationship between the futures and spot market results in the comovement of price
series in two markets. Comovement of price series of both markets is evidence that price
movement in both markets is cointegrated, but evidence of cointegration does not tell
anything regarding the speed of price discovery in the market; rather it conveys very
significant information regarding the strength of the basis (i.e. futures price –spot price).
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If on the date of the maturity of the contract, price series in two markets converges (see
Figure 2.1), it implies that cost-of-carry model holds good and both the series have long
run relationship. If reverse holds, then it implies that the futures are mispriced and may
not be an efficient price discovery vehicle. For an efficient convergence on the maturity
date the basis is required to be predictable, but predictable basis does not necessarily
imply that speedier price discovery takes place in the futures market.
Figure 2.1 Cost of Carry model: Price convergence of Futures and Equity prices
2.2.4 Expectancy Model of Futures Pricing
According to cost of carry model, the futures price must exceed the spot price by
the amount of cost of carry for the period remaining for maturity of the futures. This is
referred to as full cost of carry. In case futures price is not at full cost of carry to the spot
price then the process of arbitrage sets in. In some cases we often find that futures price is
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not only at full cost of carry but at discount to the spot price. Clearly, the process of
arbitrage appears to be failing here. In such cases either arbitrage cannot be executed or
gains are too little to offset the transaction and delivery costs. Expectancy theory of
futures pricing states that futures price is a reflection of future spot price. It presents a
view of what the spot is likely to be at the maturity of futures period, considering the
demand and supply situation expected to prevail then.
The expectancy model suggests that relationship is between the futures price and
future spot price and is not between the futures price and current spot price. If that be the
case, futures would defy the basic definition of derivatives. Expectancy model relates to
the expected direction of price in futures. If futures trades lower than the spot it suggests
that price is expected to be lower in future.
2.2.5 Hedging with Futures
Hedge is used to reduce the risk associated with a cash position or anticipated
cash position. Keynes in his “Treatise on Money (1930)” envisioned futures market
as an insurance scheme for hedgers, who pay premium to speculators for taking their
risk. The basic assumption here is that hedgers are generally long in cash market and
therefore, they need to hedge their position by taking short position in forward
market or futures market.
In general, for a position consisting of a number, ‘Xi’ of physical units held in
market “i”, hedge may be defined as a position in market “j” of size ‘Xj*’units such
that the price risk of holding ‘Xi’ and ‘Xj*’from time ‘t1’to ‘t2’is minimized
(Johnson,1960). Therefore, Hedge ratio could be defined as the number of
‘Xj*’units (of hedging instrument) in market “j” required to hedge one unit held in
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market “i” (cash position). So, a hedger would protect his position in physical/cash
market by simultaneously selling sufficient number of futures contracts. Once the
underlying asset is sold, futures position may be squared off by taking equal and
opposite position (long position, in this case) in futures contract. Let ‘S1’, and ‘S2’
denote the spot prices, and ‘F1’ and ‘F2’ the prices of futures at ‘t1’ and ‘t2’ respectively.
Then, hedge ratio (h) is defined as:
(S2 - S1) = (F2 – F1) . h
h = (S2 - S1) / (F2 – F1) …….…..(2.2)
If the change in spot price is equal to that of futures, i.e, if the price movements are
parallel, the gain from one market offsets the loss in the other. Otherwise, he would be
left with a residual capital gain or loss.
The hedger will take a total gain (loss) arising from price movements from ‘t1’
to ‘t2’, equal to the positive (negative) value of x[(S2, - S1) - (F2 – F1)] for ‘x’ unit of
inventory.
The hedge is perfectly effective if [(S2 - S1) - (F2 – F1)] is equal to 0.
(S2 - S1) = (F2 – F1)
h = 1
This indicates parallel shift in prices in cash and futures markets. This is one of
the underlying assumptions of Keynes theory. This is a naïve approach to hedging.
However, Working (1960) has negated this assumption of parallel movement in
prices of spot and futures. He argued that this assumption is false, and an improper
standard to test the effectiveness of hedging. The effectiveness of hedging used with
commodity storage depends on inequalities in the movements of spot and futures
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prices, and on reasonable predictability of such inequalities. This implies gains from
hedging, if generalised, is
Rh* = (St+1 – St) – h * (Ft+1 – Ft) ..……….. (2.3)
In the Johnson (1960), Stein (1961), and Ederington (1979) (henceforth referred to as
JSE) methodology, spot prices are regressed on futures prices using ordinary least
squares (OLS) method.
S = a + b. F + u …….…….(2.4)
where ‘a’ is the intercept term (expected to be zero), and ‘b’, is the estimate of ‘h*’.
There are limitations of this model as mentioned by Herbst, Kare, and Marshall
(1993). For example, residuals from JSE estimation of optimal hedge ratio are serially
correlated and therefore, a Box-Jenkins autoregressive integrated moving average
(ARIMA) technique should be used to estimate the minimum risk hedge to account for
the observed serial correlation (Herbst, Kare and Caples,1989). A commonly used
alternative is first differences. The merits of levels versus differences are discussed,
in the context of foreign currency hedging, by Hill and Schneeweis (1982).
Another alternative is to specify the problem as minimizing the variance of returns
on wealth. This leads to a regression of percent price changes, which is fairly clean.
Hedge ratio is estimated as first difference of prices. So, changes in spot
price are regressed on changes in futures price.
∆S = a + b.∆F + u ………….. (2.5)
where, terms ‘a’ and ‘b’ are constants, ∆St = S(t) - S(t-1) and ∆Ft = F(t,T) - F(t-1, T)
and ‘u’ represents the error term. The term ‘b’ (slope of the line) is optimal hedge
ratio (with minimum variance).
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This was an improvement, though it retained some serious flaws. One of the
limitations emerged from the assumptions of regression. Regression can be used when
relationship between Explained Variable (St) and Explanatory Variable (Ft) is stable.
This implies constant basis irrespective of time of observation. In reality, in a direct
hedge, the basis must decline over the life of the futures contract and become zero at
maturity. Franckle (1980), in his reply to Enderington (1979), drew attention to this
point and suggested a modified hedge ratio that incorporates the declining basis.
Castelino (1990) argued that regression based hedge ratios must be time dependent.
However, he argued that time dependent hedge ratios cannot be of minimum variance.
In tests with financial futures on short term interest rates, he claimed superior results vis-
a-vis JSE by accounting for time in the hedge ratio estimation. But his results had two
limitations: (a) it is based on an arbitrage model for treasury bonds that is of limited
applicability to hedges with other futures contracts, and (b) it implicitly relies on the
stability of spot-futures relationship from the prior year into the year of the hedge. The
problem of instability of hedge ratio was also addressed by others, such as
Grammatikos and Saunders (1983), and Malliaris and Urrutia (1991). However, they did
not address the problems arising from the exclusion of time.
Equation (2.5) suggests that the relationship is not stable but time-varying.
F(t) = S(t) erT
S(t) = F(t) e-rT
Taking natural logarithm on both sides,
ln[S(t)/F(t,T)] = -rT …………..(2.6)
Equation (2.6) can be estimated as
.
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ln[S(t)/F(t,T)] = a +dT + µi ………..…(2.7)
where ‘a’ is the intercept term (expected to be zero), and ‘d’ (the slope), is the estimate
of ‘r’. Once the coefficient of ‘T’ in Equation (2.7) is estimated by regression, the
optimal hedge ratio can be estimated as:
h* = edT …………..(2.8)
An important difference between the JSE hedge ratio and that defined by
Equation (2.8) is that the later can be revised daily once the estimate of full cost of carry
is available (from a few trading days of a futures contract). The estimated hedge ratio
‘h*’ will change daily depending on the term to expiration of the futures contract. The
JSE hedge ratio ‘b’, on the other hand, is a constant estimated solely from the past
data. Historical data may provide poor estimate of the minimum variance hedge ratio,
especially when the spot-to-futures relationship is not stable.
2.2.6 Dynamic Hedging
Following a two-period framework, which is common in studies of the
kind of dynamic hedging described here, specify the random return on
a hedged portfolio by
rt = st -bt-1ft ………….(2.9)
where bt-1 is the hedge ratio to be used in period t; st is the change in the
natural logarithm of the spot price; and ft is the change in the natural
logarithm of the futures price. The covariance matrix of spot and futures
price changes is given by
∑Ωt-1=
where Ωt-1 is the information set at t - 1.
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An investor with mean-variance tastes,
E(rt|Ωt-1) -γVar(rt|Ωt-1) ……………(2.10)
and risk aversion parameter γ>0, chooses bt-1 to maximize end-of-
period utility. The investor’s optimal demand for futures is then
b*t-1 =
- 1/2γ ……...(2.11)
where the first term is the conditional, risk-minimizing hedge ratio, and
the second term is the conditional, speculative demand for futures.
Equation (2.11) highlights the fact that the welfare-maximizing futures
position coincides with the risk-minimizing position only if speculative
demand is zero, and that ignoring conditioning information reduces the
model to its constant-hedge counterpart.
The empirical model appears below, with y the (N X2) vector
representing the conditional cash and futures price changes s and f with
mean pt, and H their conditional covariance matrix.
yt =µt +δ(ln(Ft-1) - ln(St-1)) = є t ……………..(2.12)
where є t|Ωt-1 is tv (0,Ht) and
Ht =C'C +A'є t-1є 't-1A +G'Ht-1G
ln(Ft-1) - ln(St-1), the difference in the natural logarithms of the futures
and spot price levels, is an error-correction term, motivated by Granger
(1981) and Engle and Granger (1987), which accounts for the two series
being cointegrated despite their non-stationarity. Support for an error
correction in modelling spot prices and forward or futures prices is found in
Barnhart and Szakmary (1991), Bessler and Covey (1991), Kroner and
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Sultan (1993), and Gagnon and Lypny (1997). The parameterization of the
conditional covariance matrix used here guarantees positive definiteness and
is adopted from Engle and Kroner (1995).
2.3.1 Derivatives Trading in India1
India’s tryst with equity derivatives began in the year 2000 on the NSE and BSE.
Trading first commenced in Index futures contracts, followed by index options in June
2001, options in individual stocks in July 2001 and futures in single stock derivatives in
November 2001. Since then, equity derivatives have come a long way. New products;
expanding list of eligible investors; rising volumes and best of risk management
framework for exchange traded derivatives have been the hallmark of the journey of
equity derivatives so far. India’s experience with the launch of equity derivatives market
has been extremely positive. The derivatives turnover on the NSE has surpassed the
equity market turnover. The turnover of derivatives on the NSE increased from Rs.
23,654 million (US $ 207 million) in 2000-01 to Rs. 110,104,821 million (US $ 2,161
billion) in 2008-09. The average daily turnover in this segment of the markets on the NSE
was Rs. 453,106 million in 2008-09. India is one of the most successful developing
countries in terms of a vibrant market for exchange-traded derivatives.
This reiterates the strengths of the modern development of India’s securities
markets, which are based on nationwide market access, anonymous electronic trading,
and a predominantly retail market. There is an increasing sense that the equity derivatives
market is playing a major role in shaping price discovery.
1The details given under Section-2.3 are largely based upon the information available on the NSE Fact Book (2009).
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2.3.2 Trading Mechanism
The derivatives trading system at NSE is called NEAT-F&O trading system. It
provides a fully automated screen-based trading for all kind of derivative products
available on NSE on a nationwide basis. It supports an anonymous order driven market,
which operates on a strict price/time priority. It provides tremendous flexibility to users
in terms of kinds of orders that can be placed on the system. Various time and price
related conditions like Immediate or Cancel, Limit/Market Price, Stop Loss, etc. can be
built into an order. Trading in derivatives is essentially similar to that of trading of
securities in the capital market segment.
The NEAT-F&O trading system distinctly identifies two groups of users. The
trading user more popularly known as trading member has access to functions such as,
order entry, order matching and order & trade management. The clearing user (clearing
member) uses the trader workstation for the purpose of monitoring the trading member(s)
for whom he clears the trades. Additionally, he can enter and set limits on positions,
which a trading member can take. 2.3.3 Contract Specification
The contract specification for stock futures traded on NSE are summarised in
Table 2.1. At any point of time there are only three contract months available for trading,
with 1 month, 2 months and 3 months to expiry. These contracts expire on last Thursday
of the expiry month and have a maximum of 3-month expiration cycle. If the last
Thursday is a trading holiday, the contracts expire on the previous trading day. A new
contract is introduced on the next trading day following the expiry of the near month
contract. All the derivatives contracts are presently cash settled.
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Table-2.1 Contract Specification for Stock Futures on National Stock Exchange
Particulars Stock Futures Security Description
FUTSTK
Underlying
Individual Securities
Contract Size
As specified by SEBI; Currently minimum Rs.2 lakhs at the time of introduction
Price Steps
Rs.0.05
Expiration Period
Upto 3 months
Trading Cycle
3 month trading cycle - the near month (one), the next month (two) and the far month (three)
Last Trading/Expiration Day
Last Thursday of the expiry month or the preceding trading day, if last Thursday is a trading holiday
Price Bands
Operating range of 20% of the base price
Source: NSE Fact Book (2009)
The long term option contracts are available for 3 serial month contracts, 3
quarterly months of the cycle March / June / September / December and 8 following
semi-annual months of the cycle June / December. Thus, at any point in time there would
be options contracts available up to 5 year tenure.
2.3.4 Selection Criteria of Stocks for Trading in Futures Market
Eligibility Criteria of Stocks
The eligibility criteria for inclusion of scrips in futures market segment is as
under:
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• The stock is chosen from amongst the top 500 stocks in terms of average daily market
capitalization and average daily traded value in the previous six months on a rolling
basis.
• The stock’s median quarter sigma order size over the last six months should not be less
than Rs.5 lakhs.
• The market wide position limit (MWPL) in the stock should not be less than Rs.100
crores.
The criteria for exclusion of scrips in futures market segment will be as under:
• For an existing stock futures, the continued eligibility criteria is that market wide
position limit in the stock should not be less than Rs.60 crores and stock’s median
quarter-sigma order size over the last six months shall be not less than Rs.2 lakhs. If the
existing security fails to meet the eligibility criteria for three months consecutively, then
no fresh month contract would be issued on that security. However, the existing
unexpired contracts would be permitted to trade till expiry and new strikes would also be
introduced in the existing contract months. Further, once the stock is excluded from the
futures list, it is not considered for re-inclusion for a period of one year. 2.3.5 Re-introduction of dropped stocks
A stock which is dropped from derivatives trading may become eligible once
again. In such instances, the stock is required to fulfill the eligibility criteria for three
consecutive months to be re-introduced for derivatives trading.
2.3.6 Trading Volume and Contract Traded
The total turnover on the F&O Segment increased by 60.43 % to Rs.17,663,665
crores (US$3,913,085 million) during 2009-10 as compared with Rs.11,010,482 crores
(US$2,161,037 million) during 2008
Rs.72,392 crores (US$16,037 million). The business growth of F&O segment a
number of contracts traded during the year is presented in Table
Business Growth of Futures & Options segment
The product-wise number of contracts traded during 2008
Figure 2.3. The total number of contracts traded increased by 54.68% to 66 crores
contracts during 2008-09. Out of the total contracts traded, 33.71% of the contracts were
traded on Stock futures followed by index options on which 32.26% of the contracts w
traded. Number of contracts traded on Index futures was 32.01% while 2.02% of the total
contracts were traded on stock options.
(US$2,161,037 million) during 2008-09. The average daily turnover during 2009
Rs.72,392 crores (US$16,037 million). The business growth of F&O segment a
number of contracts traded during the year is presented in Table 2.2 and Figure
Figure 2.2 Business Growth of Futures & Options segment in National Stock Exchange
wise number of contracts traded during 2008-09 is presented in
The total number of contracts traded increased by 54.68% to 66 crores
09. Out of the total contracts traded, 33.71% of the contracts were
traded on Stock futures followed by index options on which 32.26% of the contracts w
traded. Number of contracts traded on Index futures was 32.01% while 2.02% of the total
contracts were traded on stock options.
47
09. The average daily turnover during 2009-10 was
Rs.72,392 crores (US$16,037 million). The business growth of F&O segment and the
Figure 2.2.
in National Stock Exchange
is presented in
The total number of contracts traded increased by 54.68% to 66 crores
09. Out of the total contracts traded, 33.71% of the contracts were
traded on Stock futures followed by index options on which 32.26% of the contracts were
traded. Number of contracts traded on Index futures was 32.01% while 2.02% of the total
48
Tab
le-2
.2
Bus
ines
s G
row
th o
f Fut
ures
& O
ptio
ns s
egm
ent i
n N
atio
nal S
tock
Exc
hang
e
Y
ear
In
dex
Futu
res
St
ock
Futu
res
Inde
x O
ptio
ns
Stoc
k O
ptio
ns
Tot
al
A
vera
ge
Dai
ly
Tra
ding
V
olum
e (R
s.cr
s)
Pu
t
Cal
l
Put
C
all
Con
trac
ts
Tra
ded
(No.
)
Tra
ding
V
olum
e (R
s.cr
s)
Con
trac
ts
Tra
ded
(No.
)
Tra
ded
Vol
ume
(Rs.
crs)
Con
trac
ts
Tra
ded
(No.
)
Tra
ded
Val
ue
(Rs.
crs)
Con
trac
ts
Tra
ded
(No.
)
Not
iona
l T
rade
d V
olum
e (R
s.cr
s)
Con
trac
ts
Tra
ded
(No.
)
Not
iona
l T
rade
d V
olum
e (R
s.cr
s)
Con
trac
ts
Tra
ded
(No.
)
Not
iona
l T
rade
d V
olum
e (R
s.cr
s)
Con
trac
ts
Tra
ded
(No.
)
Not
iona
l T
rade
d V
olum
e (R
s.cr
s)
2000
90
,580
2,
365
90,5
80
2,36
5 12
2001
1,
025,
588
21,4
82
1,95
7,85
6 51
,516
11
3,97
4 2,
466
61,9
26
1,30
0 76
8,15
9 18
,780
26
9,37
0 6,
383
4,19
6,87
3 10
1,92
7 41
3
2002
2,
126,
763
43,9
51
10,6
76,8
43
286,
532
269,
674
5,67
0 17
2,56
7 3,
577
2,45
6,50
1 69
,644
1,
066,
561
30,4
89
16,7
68,9
09
439,
864
1,75
2
2003
17
,191
,668
55
4,46
2 32
,368
,842
1,
305,
949
1,04
3,89
4 31
,801
68
8,52
0 21
,022
4,
248,
149
168,
174
1,33
4,92
2 49
,038
56
,886
,776
2,
130,
649
8,38
8
2004
21
,635
,449
77
2,17
4 47
,043
,066
1,
484,
067
1,87
0,64
7 69
,373
1,
422,
911
52,5
81
3,94
6,97
9 13
2,06
6 1,
098,
133
36,7
92
77,0
17,1
85
2,54
7,05
3 10
,067
2005
58
,537
,886
1,
513,
791
79,5
86,8
52
2791
721
6,41
3,46
7 16
8,63
2 6,
521,
649
169,
837
4,16
5,99
6 14
3,75
2 1,
074,
780
36,5
18
156,
300,
630
4,82
4,25
0 19
,220
2006
81
,487
,424
2,
539,
575
104,
955,
401
3,83
0,97
2 12
,632
,349
39
8,21
9 12
,525
,089
39
3,69
3 4,
394,
292
161,
902
889,
018
31,9
09
216,
883,
573
7,35
6,27
1 29
,543
2007
15
6,59
8,57
9 3,
820,
667
203,
587,
952
7,54
8,56
3 26
,667
,882
66
8,81
6 28
,698
,156
69
3,29
5 8,
002,
713
308,
443
1,45
7,91
8 50
,693
42
5,01
3,20
0 13
,090
,478
52
,153
2008
21
0,42
8,10
3 3,
570,
111
221,
577,
980
3,47
9,64
2 11
0,43
1,97
4 2,
002,
544
101,
656,
470
1,72
8,95
7 9,
762,
968
171,
843
3,53
3,00
2 57
,384
65
7,39
0,49
7 11
,010
,482
45
,311
2009
17
8,30
6,88
9 3,
934,
389
145,
591,
240
5,19
5,24
7 16
7,68
3,92
8 4,
049,
266
173,
695,
595
3,97
8,69
9 10
,614
,147
38
9,15
8 3,
402,
123
116,
907
679,
293,
922
17,6
63,6
65
72,3
92
Sour
ce: N
SE F
act B
ook
(201
0)
49
Figure 2.3 Product-wise Number of Contracts Traded on National Stock Exchange
during 2008-09
The traded value in stock futures increased by 49.30 % to Rs.5,195,247 crores
(US $ 1,150,919 million) during 2009-10 over the turnover of Rs.3,479,642 crores (US $
682,952 million) during 2008-09.
2.3.7 Charges
Brokerage Charges
The maximum brokerage chargeable by a trading member in relation to trades in
the contracts admitted to dealing on the F&O segment of NSE is fixed at 2.5% of the
contract value in the case of index futures and stock futures. In the case of index options
and stock options it is 2.5% of notional value of the contract [(Strike Price + Premium) ×
Quantity)], exclusive of statutory levies.
50
Transaction Charges
The transaction charges payable to the exchange by the trading member for the
trades executed by him on the F&O segment were fixed at the rate of Rs.2 per lakh of
turnover (0.002%) subject to a minimum of Rs.1,00,000 per year.
Securities Transaction Tax
The trading members are also required to pay securities transaction tax (STT) on
non-delivery transactions at the rate of 0.017 (payable by the seller) for derivatives w. e. f
June 1, 2008.
Contribution to Investor Protection Fund (F&O Segment)
The trading members contribute to Investor Protection Fund of F&O segment at
the rate of Re.1/- per Rs.100 crores of the traded value (each side) in case of Futures
segment and Re.1/- per Rs.100 crores of the premium amount (each side) in case of
Options segment.
2.3.8 Clearing and Settlement
NSCCL undertakes clearing and settlement of all trades executed on the F&O
Segment of the Exchange. It also acts as legal counterparty to all trades on this segment
and guarantees their financial settlement. The Clearing and Settlement process comprises
of three main activities, viz., Clearing, Settlement and Risk Management.
Clearing Mechanism
The clearing mechanism essentially involves working out open positions and
obligations of clearing (self-clearing/trading-cum-clearing/professional clearing)
members. This position is considered for exposure and daily margin purposes. The open
positions of clearing members (CMs) are arrived at by aggregating the open positions of
51
all the trading members (TMs) and all custodial participants clearing through him, in
contracts in which they have traded. A TM’s open position is arrived at as the summation
of his proprietary open position and clients’ open positions, in the contracts in which he
has traded. While entering orders on the trading system, TMs are required to identify the
orders. These orders can be proprietary (if they are their own trades) or client (if entered
on behalf of clients) through ‘Pro/Cli’ indicator provided in the order entry screen.
Proprietary positions are calculated on net basis (buy - sell) for each contract.
Clients’ positions are arrived at by summing together net (buy - sell) positions of
each individual client. A TM’s open position is the sum of proprietary open position,
client open long position and client open short position.
Settlement Mechanism
All futures and options contracts are cash settled i.e. through exchange of cash.
The settlement amount for a CM is netted across all their TMs/clients, with respect to
their obligations on mark-to-market (MTM), premium and exercise settlement. For the
purpose of settlement, all CMs are required to open a separate bank account with
National Securities Clearing Corporations Ltd. (NSCCL) designated clearing banks for
F&O segment.
Settlement of Futures Contracts on Index or Individual Securities
Futures contracts have two types of settlements, the MTM settlement which
happens on a T+1 day basis and the final settlement which happens on the next day of the
expiry day.
• MTM Settlement for Futures: The positions in futures contracts for each member are
marked to-market to the daily settlement price of the relevant futures contract at the end
52
of each day. The CMs who have suffered a loss are required to pay the mark-to-market
(MTM) loss amount in cash which in turn passed on to the CMs who have made a MTM
profit. This is known as daily mark-to-market settlement. CMs are responsible to collect
and settle the daily MTM profits/losses incurred by the TMs and their clients clearing and
settling through them. Similarly, TMs are responsible to collect/pay losses/ profits
from/to their clients by the next day. The pay-in and pay-out of the mark-to-market
settlement are effected on the day following the trade day (T+1).
After completion of daily settlement computation, all the open positions are reset
to the daily settlement price. Such positions become the open positions for the next day.
• Final Settlement for Futures: On the expiry day of the futures contracts, after the
close of trading hours, NSCCL marks all positions of a CM to the final settlement price
and the resulting profit/loss is settled in cash. Final settlement loss/profit amount is
debited/credited to the relevant CM’s clearing bank account on the day following expiry
day of the contract.
• Settlement Prices for Futures: Daily settlement price on a trading day is the closing
price of the respective futures contracts on such day. The closing price for a futures
contract is currently calculated as the last half an hour weighted average price of the
contract in the F&O Segment of NSE. Final settlement price is the closing price of the
relevant underlying index/security in the Capital Market segment of NSE, on the last
trading day of the contract.
The closing price of the underlying Index/security is currently its last half an hour
weighted average value in the Capital Market Segment of NSE.
53
2.3.9 Risk Management System
NSCCL has developed a comprehensive risk containment mechanism for the
F&O segment. The salient features of risk containment measures on the F&O segment
are:
• The financial soundness of the members is the key to risk management.
Therefore, the requirements for membership in terms of capital adequacy (net
worth, security deposits) are quite stringent.
• NSCCL charges an upfront initial margin for all the open positions of a Clearing
Member (CM). It specifies the initial margin requirements for each
futures/options contract on a daily basis. It follows VaR-based margining
computed through Standard Portfolio Analysis of Risk (SPAN) system. The CM
in turn collects the initial margin from the trading members (TMs) and their
respective clients.
• The open positions of the members are marked to market based on contract
settlement price for each contract at the end of the day. The difference is settled in
cash on a T+1 basis.
• NSCCL’s on-line position monitoring system monitors a CM’s open position on a
real-time basis. Limits are set for each CM based on his effective deposits. The
on-line position monitoring system generates alert messages whenever a CM
reaches 70 %, 80 %, 90 % and a disablement message at 100 % of the limit.
NSCCL monitors the CMs for Initial Margin violation, Exposure margin
violation, while TMs are monitored for Initial Margin violation and position limit
violation.
54
• CMs are provided a trading terminal for the purpose of monitoring the open
positions of all the TMs clearing and settling through him. A CM may set limits
for a TM clearing and settling through him. NSCCL assists the CM to monitor the
intra-day limits set up by a CM and whenever a TM exceeds the limits, it stops
that particular TM from further trading.
• A member is alerted of his position to enable him to adjust his exposure or bring
in additional capital. Margin violations result in disablement of trading facility for
all TMs of a CM in case of a violation by the CM.
• A separate Settlement Guarantee Fund for this segment has been created out of
deposits of members.
The most critical component of risk containment mechanism for F&O segment is
the margining system and on-line position monitoring. The actual position monitoring
and margining is carried out on-line through Parallel Risk Management System (PRISM)
using SPAN(R)2 (Standard Portfolio Analysis of Risk) system for the purpose of
computation of on-line margins, based on the parameters defined by SEBI.
2.3.10 NSE - SPAN(R) (Standard Portfolio Analysis of Risk)
The objective of NSE-SPAN is to identify overall risk in a portfolio of all futures
and options contracts for each member. The system treats futures and options contracts
uniformly, while at the same time recognising the unique exposures associated with
options portfolios, like extremely deep out-of-the-money short positions and inter-month
risk. Its over-riding objective is to determine the largest loss that a portfolio might
2SPAN® is a registered trademark of the Chicago Mercantile Exchange (CME) used here under license.
55
reasonably be expected to suffer from one day to the next day based on 99% VaR
methodology.
SPAN considers uniqueness of option portfolios. The following factors affect the value of
an option:
i. Underlying market price.
ii. Volatility (variability) of underlying instrument, and
iii. Time to expiration.
As these factors change, the value of options maintained within a portfolio also
changes. Thus, SPAN constructs scenarios of probable changes in underlying prices and
volatilities in order to identify the largest loss a portfolio might suffer from one day to the
next. It then sets the margin requirement to cover this one-day loss.
The complex calculations (e.g. the pricing of options) in SPAN are executed by
NSCCL. The results of these calculations are called risk arrays. Risk arrays, and other
necessary data inputs for margin calculation are provided to members daily in a file
called the SPAN Risk Parameter file. Members can apply the data contained in the Risk
Parameter files, to their specific portfolios of futures and options contracts, to determine
their SPAN margin requirements. Hence, members need not execute a complex option
pricing calculations, which is performed by NSCCL. SPAN has the ability to estimate
risk for combined futures and options portfolios, and also re-value the same under various
scenarios of changing market conditions. NSCCL generates six risk parameters file for a
day taking into account price and volatilities at various time intervals and are provided on
the website of the Exchange.
56
2.3.11 Margins
The margining system for F&O segment is as below:
• Initial margin: Margin in the F&O segment is computed by NSCCL upto client
level for open positions of CMs/TMs. These are required to be paid up-front on
gross basis at individual client level for client positions and on net basis for
proprietary positions. NSCCL collects initial margin for all the open positions of a
CM based on the margins computed by NSE-SPAN. A CM is required to ensure
collection of adequate initial margin from his TMs up-front. The TM is required
to collect adequate initial margins up-front from his clients.
• Premium Margin: In addition to Initial Margin, Premium Margin is charged at
client level.
This margin is required to be paid by a buyer of an option till the premium settlement is
complete.
• Assignment Margin for Options on Securities: Assignment margin is levied in
addition to initial margin and premium margin. It is required to be paid on
assigned positions of CMs towards interim and final exercise settlement
obligations for option contracts on individual securities, till such obligations are
fulfilled. The margin is charged on the net exercise settlement value payable by a
CM towards interim and final exercise settlement.
• Exposure Margins: Clearing members are subject to exposure margins in
addition to initial margins.
• Client Margins: NSCCL intimates all members of the margin liability of each of
their client.
57
Additionally members are also required to report details of margins collected from clients
to NSCCL, which holds in trust client margin monies to the extent reported by the
member as having been collected from their respective clients.
2.3.12 Position Limits
The market wide limit of open position (in terms of the number of underlying
stock) on futures and option contracts on a particular underlying stock should be 20% of
the number of shares held by non-promoters in the relevant underlying security i.e. free–
float holding. This limit is applicable on all open positions in all futures and option
contracts on a particular underlying stock. The enforcement of the market wide limits is
done in the following manner:
• At end of the day the exchange tests whether the market wide open interest for
any scrip exceeds 95% of the market wide position limit for that scrip. In case it
does so, the exchange takes note of open position of all client/TMs as at end of
that day for that scrip and from next day onwards they can trade only to decrease
their positions through offsetting positions.
• At the end of each day during which the ban on fresh positions is in force for any
scrip, the exchange tests whether any member or client has increased his existing
positions or has created a new position in that scrip. If so, that client is subject to a
penalty equal to a specified percentage (or basis points) of the increase in the
position (in terms of notional value). The penalty is recovered before trading
begins next day.
• The normal trading in the scrip is resumed after the open outstanding position
comes down to 80% or below of the market wide position limit. Further, the
58
exchange also checks on a monthly basis, whether a stock has remained subject to
the ban on new position for a significant part of the month consistently for three
months. If so, then the exchange phases out derivative contracts on that
underlying.
2.3.13 Trading Member wise Position Limits
Futures and Option contracts on individual securities
i). For stocks having applicable market-wise position limit (MWPL) of Rs.500
crores or more, the combined futures and options position limit is 20% of
applicable MWPL or Rs. 300 crores, whichever is lower and within which stock
futures position cannot exceed 10% of applicable MWPL or Rs.150 crores,
whichever is lower.
ii). For stocks having applicable market-wise position limit (MWPL) less than
Rs.500 crores, the combined futures and options position limit would be 20% of
applicable MWPL and futures position cannot exceed 20% of applicable MWPL
or Rs.50 crores whichever is lower. The Clearing Corporation shall specify the
trading member-wise position limits on the last trading day of the month which
shall be reckoned for the purpose during the next month.
Client level position limits
The gross open position for each client, across all the derivative contracts on an
underlying, should not exceed 1% of the free float market capitalization (in terms of
number of shares) or 5% of the open interest in all derivative contracts in the same
underlying stock (in terms of number of shares) whichever is higher.
59
Stock Futures & Options
For stocks having applicable market-wise position limit (MWPL) of Rs.500
crores or more, the combined futures and options position limit is 20% of applicable
MWPL or Rs.300 crores, whichever is lower and within which stock futures position
cannot exceed 10 % of applicable MWPL or Rs.150 crores, whichever is lower.
For stocks having applicable market-wise position limit (MWPL) less than Rs.500
crores, the combined futures and options position limit is 20% of applicable MWPL and
futures position cannot exceed 20 % of applicable MWPL or Rs.50 crores whichever is
lower.
2.4 Conclusion
India is one of the most successful developing countries in terms of a vibrant
market for exchange-traded derivatives. This reiterates the strengths of the modern
development of India’s securities markets, which are based on nationwide market access,
anonymous electronic trading, and a predominantly retail market. This chapter briefly
introduces about the definition and user of derivatives and its instruments and also
discusses about the futures markets and its economic functions in detail. The analysis
revealed that the futures markets provide benefits to participating traders by reducing
transaction costs, by providing a more efficient flow of information among traders, and
by shifting risks among them. Besides, the stock futures market in India has shown a
remarkable growth both in terms of volumes and numbers of traded contracts. The equity
futures market is playing a major role in shaping price discovery and acts as major risk
management tool for hedging against adverse price movement.
60
Besides, the present study encompasses in its scope an analysis of brief history of
derivatives trading in India and trading mechanism of stock futures market at National
Stock Exchange (NSE). The regulatory bodies of Futures & Options market govern the
activities of clearing and settlement of all trades executed on the F&O Segment of the
Exchange and also they have developed a comprehensive risk containment mechanism
for the F&O segment. The regulatory bodies govern the institutional features of the
futures markets through effective regulation and policy developments focusing on future
prospects and challenges of futures market.
